How to avoid an inheritance tax charge on life insurance payouts
Life insurance policies are intended to pay out a cash lump sum to your loved ones on your death. Without taking any action, the cash lump sums paid are simply treated like most other assets and form part of your taxable estate for inheritance tax (IHT) purposes, often triggering a significant IHT bill. However, you can take steps to avoid IHT by writing these policies into ‘trust’.
What is a trust?
A trust is a legal arrangement that allows you to gift the cash lump sum payable from your life insurance policy to your chosen beneficiary/beneficiaries. Once you have done so, the policy is looked after by a third party, known as the trustees, chosen by you. By placing the insurance policy into trust, you effectively give up ownership of it to the trustees for them to hold for the beneficiary/beneficiaries.
How do I set up a trust?
Setting up the trust can be as straightforward as asking the policy provider to send you their standard form of trust document when setting up the policy and then completing the form appropriately. In some cases, the standard form of trust document will not be fully suitable and a more bespoke document may be required.
If the policy has already been set up, you can still, in most circumstances, draw up a lifetime trust to capture the policy proceeds on your death which essentially remains dormant unless and until a lump sum is paid to the trustees of the trust on your death.
Are there different types of trusts?
There are different types of trusts and the most suitable type of trust depends on your personal circumstances and the control that you would wish to impose over the trust assets.
It is not uncommon for married couples or those in a civil partnership to make use of discretionary trusts. This is because while placing your policy into a simple trust for the benefit of your spouse or civil partner will mean there is no IHT on your death, the lump sum payment to your spouse/civil partner following your death simply increases the value of their estate on their death and may trigger IHT.
The way in which a discretionary trust is operated relies on the discretion of the trustees who are appointed when you create the trust. The trustees choose who will benefit from the trust assets and when, guided by any Letter of Wishes that you leave for their reference.
The trust can include powers to loan money to beneficiaries, a useful tax planning tool for your spouse/civil partner as they will be able to do whatever they like with the money loaned to them, but the loan will be treated as a debt against their estate on their death. This prevents their estate being increased by the value of the lump sum payout and IHT becoming payable.
What are the advantages / disadvantages of trusts?
Not only will writing the policies in trust take them out of the IHT net but it will also enable them to be administered, for the most part, without the need for a Grant of Probate (or equivalent) and therefore the money can be accessed quite soon after death.
There may be costs for setting up a trust and there may be ongoing tax charges, particularly for discretionary trusts. However, these reasons alone should not deter you from setting up a trust, bearing in mind the potential IHT saving.
What is important however, is that you take specialist legal advice to ensure that you understand which trust is right for you and your loved ones, taking all of your circumstances into account.
Sarah Clacker is an associate at law firm Seddons